The Merkley-Levin Amendment (SA 3931) is a version of the Volcker Rule. The Volcker Rule, if you'll recall, is a ban on proprietary trading at banks and bank holding companies (BHCs). If you ask Merkley and Levin's offices, they'd no doubt tell you that their amendment significantly strengthens the existing Volcker Rule language in the Dodd bill (Section 619 of S.3712). Don't be fooled — it does nothing of the sort. I spent the majority of my career as a lawyer for one of the big investment banks, and my first thought after reading Merkley-Levin was: "Wow, this would be cake to get around." Wall Street is scared of the Volcker Rule, but believe me, they're not scared of Merkley-Levin.

This requires a bit of explanation. To ban prop trading at BHCs, the law must distinguish between market-making trades and propietary trades. Market-makers stand ready and willing to buy or sell securities for their own account, at firm bid and offer prices. If an investor is looking to sell a security, the market-maker will buy the security using its own capital, and hold it in inventory until an investor who's looking to buy the security surfaces. Holding many inventories of securities (i.e., bonds, stocks, derivatives) exposes market-makers to all manner of short-term market risk, interest rate risk, foreign exchange risk, etc. This requires market-makers to do quite a bit of hedging in order to safely carry these inventories. We don't want to prevent banks from hedging the inventories they hold as market-makers, but we dowant to prevent banks from entering into trades that aren't intended to hedge a risk associated with its market-making activities — that is, purely speculative prop trades. This is a difficult and complicated task, but it can be done (I've seen it done from the inside).

Ideally, what the financial reform bill would do is just say, "Proprietary trades are banned; market-making trades are allowed," and then let the regulators work out how to define "market-making trades" and "proprietary trades." This is something that simply can't be done at the statutory level; it has to be done at the regulatory level. Unfortunately, these days it's fashionable for people to bash any sort of regulatory discretion as tantamount to letting Wall Street win. This is where Merkley-Levin comes in, because it's clearly a response to this "anti-regulatory discretion" meme.

The biggest problem with Merkley-Levin is that its authors appear to confuse "definitions with more words" with "more specificdefinitions" (and thus less of that evil regulatory discretion). Merkley-Levin prohibits "proprietary trading," which it defines very broadly, and then creates 9 categories of "permitted activities" (listed in section (d)(1) of the amendment). The categories of "permitted activities," which function like exceptions to the definition of "proprietary trading," are so ridiculously broad that they completely swallow the amendment's prop trading ban. The most important exceptions are sections (d)(1)(B), (C), and (G).

First, let's take section (d)(1)(B), which explicitly permits:

(B) The purchase, sale, acquisition, or disposition of securities and other instruments described in subsection (i)(4) in connection with underwriting, market-making, or in facilitation of customer relationships, to the extent that any such activities permitted by this subparagraph are designed to not exceed the reasonably expected near term demands of clients, customers, or counterparties.

Section (B) was obviously supposed to be the generic market-making exception — but notice, crucially, that the term "market-making" is still undefined. Instead of offering a more specific or more narrow definition of "market-making," Merkley-Levin actually weakens the Volcker Rule by creating a whole bunch of new categories of exceptions to the prop trading ban. Essentially, section (B) consists of three separate categories of permitted trades: (1) trades "in connection with underwriting"; (2) market-making trades; and (3) trades "in facilitation of customer relationships." Regulators still have to use the rulemaking process to define "market-making," which will no doubt encompass any trade which can be justified as a hedge against any risk the bank faces in its trading book.

But even if a trade can't be justified as part of the bank's market-making activities, there's literally no trade that can't be justified as "in facilitation of customer relationships." As long as the counterparty on the trade has some sort of trading relationship with the bank (e.g., the counterparty is a prime brokerage customer, or has an ISDA Master Agreement with the bank), then it's very difficult to see how the trade wouldn't come under the definition of a trade done "in facilitation of customer relationships." All counterparties are "customers" of the bank on some level, and because every trade has to have a counterparty, literally every trade could be justified as "in facilitation of customer relationships." And remember, the exception for trades "in facilitation of customer relationships" is in addition to the exception for "market-making" trades.

The limitation that any trades allowed under section (B) have to be "designed to not exceed the reasonably expected near term demands of clients, customers, or counterparties" isn't a serious limitation. At most, it would just require a trader to come up with a plausible explanation for why he decided to take on a certain position — which could be satisfied by a story about what the trader thought other market participants were going to do at the time.

Next, we have section (C), which permits:

(C) Risk-mitigating hedging activities designed to reduce risks to the banking entity or nonbank financial company.

Whereas the exception for market-making in section (B) will no doubt include trades which hedge risks in the bank's trading book, section (C) goes one step further, permitting trades which can be justified as hedging any risk in the entire BHC, not just risks in the trading book. Also, I'd expect the banks to argue that "diversification" reduces risks to the banking entity as a whole, and thus that trades which have the effect of diversifying the bank's portfolio are permitted under section (C).

Finally, we have section (G), which permits:

(G) Proprietary trading conducted by a company pursuant to paragraph (9) or (13) of section 4(c), provided that the trading occurs solely outside of the United States and that the company is not directly or indirectly controlled by a United States person.

Section 4(c)(13) of the Bank Holding Company Act is an exemption which permits certain BHCs to own foreign bank subsidiaries (and certain foreign companies). Goldman, Morgan Stanley, JPMorgan, even CIT Group — they all own foreign bank subsidiaries under section 4(c)(13). To my knowledge, all the major BHCs own foreign bank subsidiaries under section 4(c)(13).

So essentially, section (G) allows BHCs to continue their prop trading through their London offices, provided they find non-US counterparties (shouldn't be too difficult), and the trading isn't being controlled by someone in New York (fine, just send all your prop traders to London). And this is in addition to all the prop trading the banks could do out of their New York offices under the ridiculously broad "permitted activities" in sections (d)(1)(B) and (C). Seriously, this would be like taking candy from a baby for the dealer banks.

Now, I should tell you that I'm assuming that section (d)(2)(A)(i) of the Merkley-Levin Amendment will either be removed, or defined away by regulators. It's basically incompatible with the clear intent of the amendment, so I'm pretty confident that it'll be taken out (if not in the Senate, then in conference). Section (d)(2)(A)(i) prohibits even permitted activities if they:

(i) would involve or result in a material conflict of interest (as such term shall be defined jointly by rule) between the banking entity or the nonbank financial company and its clients, customers, or counterparties.

This is simply incompatible with market-making, which involves taking the opposite side of clients' trades, and it's the clear intent of Merkley-Levin to allow market-making. If for some bizarre reason this section doesn't get removed, regulators would have to consider the clear intent of the amendment to allow market-making in defining "material conflict of interest," and would effectively be forced to define "material conflict of interest" so narrowly that it might as well not exist as a limitation. The fact that this section is even in the amendment I think is indicative of how poorly it was drafted.

People often ask why I say that complicated financial regulations can't be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.

9
comments:

Anonymous
said...

Not sure of what your point.

All institutions differentiate between prop trades and 'flow' trades. It is the only way banks can distinguish between the trading ability and the hedging ability of a trader when it comes to bonus time.

Books with 'flow' trades have little risk. Regulators should have no trouble making this distinction.

Also, market makers typically simply post a bid/offer and levels.

They don't put out 'pitch books' pushing structures that they know are defective and are designed to profit some other customer.

What I take from the article is that the "regulators" who "should have no trouble making this distinction" will never get the opportunity to do so: the drafters of the statute have created (at least) 3 lovely, massive passages to Prop Trade City.

EoC, you have a political background; who drafts these statutes as a practical matter, junior staffers? Is there any concept of vetting them with people in the industry who actually know something about the field (e.g., you)?

AlfonsoG, lets assume for a minute the banks ARE fighting "tooth and nail" and so are the republicans... It is probably because they would prefer something that is better drafted. EoC might be right that any IB lawyer worth his salt can drive coaches and horses through the definitions but a smart IB will realise after the next bubble the fact that what they were doing was perfectly legal won't stop the government bringing a spurious, populist suit against them. There may even be some of the banks and republicans that would prefer to have regulations that were not written by retards and that would actually be effective at bringing about financial stability.

Danny

PS They are running out of time to prevent the next bubble. If the republicans really wanted to stick it to the Democrats they'd let them pass this bill with Democrat written all over it and then remind people when these chickens come home to roost:

Anonymous, please don't insult our collective intelligences, as you are currently doing. The Republicans aren't looking for better wording for Volcker Rule legislation, they are looking to kill it. The parliamentary shenanigans show the Republicans at their most brilliantly cynical. First, Shelby objects to a vote. Then Merkley and Levin attach the amendment to Brownback's amendment. Shelby says he'll vote for the amendment, knowing that Shelby will withdraw his own amendment and kill Merkley-Levin. Shelby gets to say he would have voted for it while having succeeded in playing a key part in killing it.

Alfonso, wouldn't you need some intelligence in order for people to insult it?

So far your claim is good is based on a charlatan - Simon Johnson - backing it and a claim that all the banks and republicans are fighting it.

Well no one with more than one brain cell wants to have laws that are poorly drafted like this one.

No one with more than one brain cell will fail to see what having a law that allows banks to carry on trading but is presented as stopping them doing so will lead after the next crash to more of the show boating senate hearings like GS sat through where GS explains what they were doing was perfectly legal and some dimwit politician pretends to be shocked, shocked to find out that the idiot law he wrote led to this behaviour.

Given you don't see this, one can assume you are not in the "someone with more than one brain cell" category.

Danny

PS This is even before the discussion of whether what they are trying to achieve is helpful or not.

Why not allow prop trading and force firms to disgorge all profits above a minimal level. If market-making is done without coincidently finding another side to the trade, it drifts the P&L, where another opportunity to apply the rule should exist.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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